Marginal Tax Rates and Income

July 8, 2013

To what extent do marginal tax rates matter for individual decisions to work and invest? The answer is essential for public policy and its role in shaping economic growth, says Karel Mertens of Cornell University.

Mertens found large income responses to changes in marginal tax rates for every income level.

Mertens bases her finding on a new methodological approach and a hypothetical marginal tax rate cut for the top 1 percent of income earners.

A 1 percent reduction in the marginal tax rate would increase income 0.5 percent in first year, 1 percent in the second year, and another 1 percent the third year.

The income response is more than twice as much for a tax reform cutting marginal rates more broadly.

A top marginal rate cut raises real gross domestic product (GDP) by up to 0.3 percent after two years and also has a positive effect on incomes outside of the top 1 percent.

However, marginal rate cuts targeting top incomes lead to greater income inequality.

These empirical results reinforce the findings by a number of recent studies of large effects of aggregate tax changes on real GDP both in the United States and internationally. The results imply that raising marginal tax rates to resolve budget deficits comes at a high price and that a proportional across-the-board tax cut increases the rate of economic growth and does not necessarily lead to greater income concentration at the top.

The results are also consistent with the strong negative correlation between top tax rates and top 1 percent income shares documented by other economists.

However, the positive response of real GDP and incomes outside the top 1 percent to a top marginal rate cut contradict explanations based on tax avoidance or on the notion that the effects come entirely at the expense of lower incomes.

The results are important for assessing the role of income taxation for macroeconomic stabilization and the impact of austerity programs, for understanding the empirical relationship between income taxes and inequality, and for optimal tax policy.